Year-end tax strategies

With financial year-end approaching and rule changes aplenty, what are the tax strategies you might consider and the potential pitfalls?

Key Points

Rule changes to come into force on July 1 mean you need to examine your position now

Saving the one-off flood levy is attractive but situations will vary

In many circumstances, pre-paying expenses and deferring income will make sense

This year, as with every other, newspapers, websites and newsletters are loaded with tips to help lighten the taxman’s grip on your wallet. Reading them is the easy part. Making sense of them is more difficult.

So, let’s look at the most popular strategies for reducing this year’s tax burden and see which ones may work for you.

Prepay expenses

Each year, taxpayers are encouraged to prepay expenses to get a deduction in the current year. Typical examples are interest on investment loans, repairs and running costs on investment properties, professional services, income insurance premiums and donations. This year, even the potential to save on the one-off flood levy gets a mention.

Prepaying expenses can be a sensible strategy. But it’s conditional on three factors:

The expense would have been ordinarily incurred shortly after 1 July;

You receive a discount that takes into account the time value of money; or

A permanent tax benefit is received. For instance, you’ll be on a lower marginal tax rate in the subsequent year or, for this year, saving the 1% flood levy (0.5% for those with taxable income of $50,000-$100,000).

If you are bringing forward expenses with no price discount on those expenses, then you need to allow for the opportunity cost of making the payment early. Even if you are on the top marginal tax rate, the ‘timing’ tax benefit is only worth 46.5% of the payment multiplied by one year’s interest. This comes at a cost—interest on 100% of the payment amount.

In the absence of permanent benefits from making the prepayment, or a discount, once you are accelerating a payment by six months or more, it could end up as a net cost[1]. With the flood levy saving included, this might extend to ten months or more[2].

Deferral of income

Deferring income or gains until 1 July has the same effect as a prepayment (reducing taxable income this year). The strategy can make sense in similar circumstances to prepaying expenses.

For those in a position to do so, it might be worth deferring income until July to avoid the flood levy and get an extra year to pay the tax. Just be sure this doesn’t result in you ending up in a higher tax bracket next year. There is little point saving 1% flood levy, and some interest, only to find out you’ve gone from a marginal tax rate of 38.5% this year to 46.5% next year.

Deferring capital gains for a short period can also make sense. If you were planning on selling in the next few weeks anyway, why not wait until after 1 July?

Again, make sure you don’t end up pushing yourself into a higher tax bracket in the following year. And don’t allow a CGT bill to cause you to hold off selling indefinitely. Too many investors, in wanting to delay the payment of CGT, manage to avoid it altogether by turning profits into losses.

Beating Government rule changes

In Beating the budget bootstrap we highlighted a strategy that may help with the new super contributions surcharge on those with income over $300,000. Legislation hasn’t yet been passed so if you wish to make use of it, you and your adviser need to assume the laws will work in the manner described.

In addition, there are other forthcoming changes to the law to consider:

Reduction in concessional contributions for over-50s. The cap will fall from $50,000 to $25,000 from 2012/13 onwards. The transitional measures that would retain a higher cap for those with balances under $500,000 have also been deferred. If you wish to contribute more than $25,000, it might make sense to do so now.

Government co-contribution to super. From 2012/13 onwards the cap falls from $61,920 to $46,920 and the maximum co-contribution falls from $1,000 to $500. So, pre-30 June this year might be the last chance for you to get a co-contribution.

Ban on off-market transfers. From 1 July 2012, off-market transfers will no longer be permitted between SMSFs and related parties. This will impact in-specie contributions and other transfers between members and their SMSFs. While it is not clear yet exactly what future process will be required to deal with this situation, if this is something you’ve been thinking about, you may want to act now.

Just remember to take into account the acceleration of any CGT due to the transfer. Even if, post 1 July, you and your SMSF have to sell and buy shares on-market, the additional transaction costs could be eaten up by the impact of bringing forward CGT to the current year (particularly if you have a large capital gain that triggers the 1% flood levy and a higher marginal tax rate).

Health insurance means testing. The introduction, from 1 July, of means testing for the 30% private health insurance rebate has seen insurers offer policyholders the option of prepaying for a year or more. Thirty percent is a large permanent benefit and, if you are affected by the new rules, this might be one of those situations where a prepayment makes a lot of sense. Just make sure you understand the fine print and the consequences if you need to change or cancel the policy.

Other changes. July 1 will also see changes to the spouse rebate on super contributions and the rolling over of termination payments into super. These changes won’t affect many people but consider taking action prior to 30 June if they affect you.

Tax loss selling

The strategy of selling loss-making shares to offset any capital gains made during the course of the year makes a lot of sense. But keep in mind that you won’t simply be able to sell, say, 1,000 BHP shares on 30 June and repurchase them in early July—known as a ‘wash sale’.

The Tax Office takes a dim view on wash sales and similar arrangements—buying the replacement shares first and using derivatives, for instance. If you are going to undertake end of year loss selling, it should be with shares you want to be permanently rid of.

A clean energy pitfall

We’ve already mentioned the risk of shifting yourself into a higher tax bracket by using year-end strategies. This is especially relevant this year due to the Clean Energy Bills.

This includes a restructure of the lower tax brackets from next year onwards. This year, a person with income of $80,000 will be in the 30% tax bracket (pre-Medicare Levy). Next year, their marginal tax rate will be 32.5% (to compensate for the higher tax free threshold).

A person on a salary of $70,000 that prepays expenses of $10,000 before 30 June this year will save $3,000 in tax and $50 in flood levy. But as a consequence they will have an extra $3,250 in tax to pay next year, plus the cost of accelerating the expense in the first place. That’s an effective pre-tax interest rate of 10%pa plus.

In a nutshell

It’s been a big year for rule changes so you need to tread carefully. Consult your advisor and remember that, whilst we can’t give personal advice, we welcome your questions. Submit them here.

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